REGULATORY PUBLIC POLICIES :

THE POSSIBILITY AND

IMPOSSIBILITY OF

RATIONAL REGULATION IN

GOVERNMENT Prof. Dr. Coskun Can Aktan

THE CONCEPT OF REGULATION

Dictionaries define regulation as a law, rule or

order prescribed by an authority to regulate

conduct. Any kind of organization (public,

private or not-for-profit etc.) may use its

authority to regulate conduct or activities.

BROADEST DEFINITION OF

REGULATION Regulation, in its broadest definition is often equated

with government. Government regulation or public regulation refers to the implementation of rules by government agencies that is backed up by law.

In other words, regulation means the employment of legal instruments for the implementation of social-economic policy objectives. For example, government may implement economic and social regulations in order to realize such goals as allocative efficiency, stabilization, a fair and just income distribution etc.

SELF-REGULATION

The opposite of government regulation is self-regulation. It means rules are imposed voluntarily and backed up by an informal code of practice (e.g. rules of membership) rather than law.

DEREGULATION

Deregulation, means state’s withdrawal of its legal powers to direct the economic conduct (pricing, entry and exit) of nongovernmental bodies. The number and/or content of government regulations may be increased or decreased due to many reasons. As a matter of fact, an interventionist government finally becomes a regulatory government. A liberal government, however does not like regulations and it favours deregulation.

TYPES OF GOVERNMENT

REGULATION

Now, let’s summarize the types of government

regulation.

In general, there are two kinds of regulations,

economic and social. Economic regulation

refers to the control of prices, the variety of

standards for products, entry and exit

conditions and standards of service in a

particular industry.

ECONOMIC REGULATION

Economic regulation consists of two types of regulations: structural regulation and conduct regulation.

The structural regulation refers to rules on market structure and aims to realize functional competition at the market. Entry-exit regulation (restrictions on entry and exit to the market) and also provision of professional licence are some kinds of structural regulation.

The conduct regulation refers to rules determining behaviour of economic agents at the market. Price control, rules for advertising etc. are examples for conduct regulation.

SOCIAL REGULATION

Social regulation consists of rules aiming to correct external economies, particularly those that impinge on health and safety. This kind of regulation is common in the area of environment, labor conditions, consumer protection etc. Instruments applied here include regulation dealing with the discharge of environmentally harmful substances, safety regulations in factories and workplaces, the obligation to include information on the packaging of goods or on labels etc.

TYPES OF REGULATIONS

Cost of Service Regulation (Price capping)

Entry Regulation (to the market, professional licenses)

Service Regulation (response time for clients, number of electricity-failure per time unit)

Standards Regulation (Quality of water, food etc.)

Content Regulation (Pornography, violence)

Environmental regulation (protecting nature.)

Traffic regulation (compulsory seat belt)

Tablo- : Type of Public Regulation and

Public Control

THE RATIONALE FOR

GOVERNMENT REGULATION

1- External economies,

2- Economies of scale,

3- Public goods,

4- Protection of consumers due to imperfect competiton,

5- Protection of “infant industries” from harmful competition,

6- Asymmetric information,

7- Moral hazard,

8- Transaction cost,

EXTERNAL ECONOMIES

Private market activities create positive and negative externalities. A positive externality exists when a producer cannot appropriate all the benefits of the activities it has undertaken. An example would be research and development that yields benefits to society (e.g., employment in industry) that the producer cannot capture. Thus, the producer's incentive is to under-invest in the activity unless government subsidized or protect it. With positive externalities, too little of the good in question is produced. With negative ones too much is made. Negative externalities such as air pollution occur when the producer cannot be charged all the costs. Since the external costs do not enter the calculations the producer makes, the producer manufactures more of the good than is socially beneficial. With both positive and negative externalities, market outcomes need some kind of regulation to be more efficient.

GOVERNMENT INTERVENTION for

NEGATIVE EXTERNALITIES A government intervention is expected to punish the

economic agents in the case of negative externalities

and correct them. On the other side, government is

expected to extend subsidies to those economic

agents, whose production or consumption activities

generate positive externalities. Pigovian taxes - to

correct the external diseconomies- and subsidies - to

encourage the activities, which generate positive

external economies- are accepted as the two most

important tools of "regulatory government”.

ECONOMIES OF SCALE AND

NATURAL MONOPOLY

Economies of scale exists when the long-run average

costs continue to decline as firm size increases. Thus,

a larger firm, is believed has always lower costs. In

other words, cost of production would be the lowest

when a single firm produced the entire output of the

industries, where economies of scale reign. Such

industries as postal and telecommunications services,

electricity, gas, water supply, transportation (especially,

railways) etc. are the typical examples, in which

economies of scale occur.

PUBLIC GOODS

IMPERFECT COMPETITION

Imperfect competition is another reason of market

failure. Imperfect competition results in inefficiencies

in the market economy. It also severely limits the

options available to consumers. In brief, imperfect

competition is bad because it results in higher

product price (and smaller output) and also limits

options for consumers.

It would be necessary for government to intervene to

the free functioning of the market economy, when

there is destructive (excessive) or limited competition

at the market.

Asymmetric Information and/or

Incomplete Information

If individulas have different information at the time they act,

markets may not perform efficiently, even when there are

advantageous trades that could be made. Economist

George Akerlof presents an example of a sued car market

in which each seller knows the value of the car she/he

wants to sell but the buyers know only the probability

distribution of the values of the cars that might be offered

for sale. There is a potential buyer who is willing to buy

each used car, but the buyer cannot through causal

inspection determine the value of any particular used car

offered for sale. All he knows is that the car might be a

lemon or might be of high quality.

Asymmetric Information and/or

Incomplete Information

Because of this asymmetry of information, the

maximum amount the buyer is willing to pay is the

average of the values of the cars believed to be

offered for sale. Because buyers will only pay the

average value, those potential sellers who have high-

quality car then find that the amount buyers are willing

to pay is less than the values of their cars. They thus

will not offer their cars for sale. This is clearly

inefficient, because for every used car there is a buyer

who wishes to buy it if he only knew the true value.

MORAL HAZARD

Moral hazard refers to the presence of incentives for

individuals to act in ways that incur costs that they do

not have to bear. For example, in medical care, a fully

insured individual has an effectively unlimited demand

for medical care, since she/he doesn't bear the cost of

the care they receive. In addition, the individual may

not have the proper incentive to take socially efficient

preventive measures, since she/he knows that the cost

of any illness or accident will be covered by insurance.

TRANSACTIONS COSTS

Market failures might result due to transaction costs

occured at the market. To the extent, consumers and

producers incur costs in becoming informed about

market opportunities and completing market

transactions, markets will not perform efficiently.

Regulation to reduce those transactions costs then

can improve efficiency. For example, in the auto

industry, global auto emissions standards can

enhance efficiency, as auto producers would not have

to produce different models for different states.

THEORIES OF REGULATION

There are two main alternative theories that

explains the logic and the rationale of

regulation.

Public interest theory of regulation,

Private interest theory of regulation

Public interest theory of regulation

Public interest theory of regulation is a part of welfare

economics. According to this theory, when markets fail

due to several reasons ( external economies,

economies of scale and natural monopoly, public

goods, imperfect competition, imperfect information

etc.) economic regulation should be imposed in order

to maximise social welfare. This theory tends to see

regulation as an outcome of sustained political effort to

overcome market failures.

Private Interest Theory Of Regulation

The second alternative view or theory on economic

regulations is called as “private interest theory of

regulation.” This theory suggests that regulation does

not protect the public at large but only the interests of

groups. According to this theory, well organized groups

will tend to benefit more from regulation than broad,

diffuse groups. In other words, the most important

prediction of this theory is that well-organized interest

groups will be winners in the regulatory process. In

brief, theory reaches a conclusion that regulation will

benefit producers at the expense of consumers.

The Chicago Theory of Economic Regulation

(The Capture Theory of Regulation)

The Chicago theory of economic regulation –which is also

called as ‘capture theory of regulation’- was develeoped by

such economists as George Stigler, Sam Peltzman, Richard

Posner, Gary Becker, all of whom had thought at the

University of Chicago.

Chicago theory of regulation suggests that it is in the

interests of producers or the beneficiaries of regulations to

gain the control of the regulatory agencies. Moreover, it is

the larger firms that have the most to gain, so it is that who

have the greater incentive to obtain such control. The

smaller, disparate and less organized firms are neglected.

THE COSTS OF REGULATION

1- Costs of formulating, implementing and

maintaining regulation by the government,

2- Cost of compliance with the rules for industry and individuals; transaction cost (Williamson, 1979.)

3- Deadweight cost (Deadweight consumer loss.)

4- Rent seeking cost

5- Resource misallocation and x-inefficiencies,

6- Moral hazard.

Table: Type of Rent Seeking Activities

Type Definition

1. Monopoly Seeking

Tullock (1967)

Bhagwati (1982)

Posner (1975)

Economic agents compete for obtaining a

pure monopoly right from govemment.

2. Tarriff Seeking

Bhagwati (1982)

Brock and Mages (1978)

Feenstra-Bhagwati (1982)

Economic agents lobby for the imposition of a tariff on import

goods. Hence, domestic producers can maximize their profits

via changing a price higher than its marginal cost.

3. Quota Seeking

(License Seeking)

Krueger (1974)

Bhagwati and

Srinıvasan (1980)

Bhagwati (1982)

At first level, economic agents lobby to expand the size and

scope of Quantitative Restrictions (QRs). At the second level,

economic agents deplore efforts to obtain a licence for

importation.

4. Transfer Seeking

Private interest groups lobby for obtaining subsidy in the form

of, for example, low cost loans, loan guarentees etc.

Some public interest groups or not-for profit organizations

lobby for obtaining grants from govemments in variety areas.

IS GOVERNMENT REGULATION NECESSARY IN A MARKET ECONOMY?

No doubt that some kind of government regulations are necessary in order to

have a better working market economy. some kind of market failure is a

legitimate and convincing reason of government regulation. But we should be

careful to distinguish two kind of regulations: “regulation as intervention in

market processes” and “regulation as framing of market processes.”

“regulation as intervention in market processes” means that

government enacts “coercive rules” for the operation of market processes.

“regulation as framing of market processes” refers to basic working rules and

institutions in a market economy. These kind of regulations does not interfere with the

decisions and choices of the individuals at the market. Individuals are free to choose

and they make their own decisions without a force or command. If government

determines an “economic constitution” -that is the general legal-institutional rules and

framework requirements of an economic system-, this can be seen the essential

institutional foundation of a market economy.

“Regulation as framing of market processes”

can be considered as “regulation by rules” and

on the other side “regulation as intervention in

market processes” can be seen as “regulation

by commands.” If this distinction is true, we

may argue that “regulations by commands” are

not suitable for the market economy, but

“regulations by rules” are rational and therefore

necessary for a proper working market

economy.

GOVERNMENT REGULATION BY COMMAND VS. REGULATION BY RULES

IS RATIONAL AND EFFICENT REGULATION POSSIBLE?

Economists, who have studied the effects of regulations generally concur two

points:

-The economic regulations that prohibit restrictive agreements and various

anticompetitive practices help the market work more efficiently.

-Most of the remaining economic regulations and some social regulations

might impose high social costs on firms without providing corresponding

improvements in benefits. These might impede the market’s ability to

function effectively. Consequently, they impair efficiency.

In general, there are two reasons for inefficient regulation. One is economic

and the other is political. The economic reason is that it is difficult for a

government authority to regulate firms because it lacks the adequate

information. The firm usually is better informed than the regulator;

moreover, it rarely has an incentive to tell the regulator all it knows. This

“information asymmetries” problem results in inefficiencies for regulation.

IS RATIONAL AND EFFICENT REGULATION POSSIBLE?

Government regulation as a “framework rule

and institution” is necessary and actually

productive for the market economy. However,

government regulation as a “command rule” is

harmful for the market economy and tends to

be counterproductive.

Prof.Dr.Coşkun Can Aktan

Social Sciences Research Society

http://www.sobiad.org

& Dokuz Eylul University, Turkey

http://www.canaktan.org